Chapter 06 - The Financing Decision

Chapter 06
The Financing Decision
Multiple Choice Questions

1. Financial leverage:
I. increases expected ROE but does not affect its variability.
II. increases breakeven, like operating leverage, but increases the rate of earnings per share
growth once breakeven is achieved.
III. is a fundamental financial variable affecting sustainable growth.
IV. increases expected return and risk to owners.
A. I and II only
B. I and III only
C. II and IV only
D. II, III, and IV only
E. I, II, III, and IV
F. None of the above.

2. The best financing choice is the one that:

A. sets the debt-to-assets ratio equal to 1.
B. trades off the tax disadvantage of debt against the signaling effects of equity.
C. maximizes expected cash flows.
D. ignores the false comfort of financial flexibility.
E. results in the lowest possible financial distress costs.

3. Homemade leverage is:

A. the incurrence of debt by a corporation in order to pay dividends to shareholders.
B. the exclusive use of debt to fund a corporate expansion project.
C. the borrowing or lending of money by individual shareholders as a means of adjusting their
level of financial leverage.
D. best defined as an increase in a firm's debt-equity ratio.
E. the term used to describe the capital structure of a levered firm.
F. None of the above.

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Chapter 06 - The Financing Decision

4. The basic lesson of the M&M theory is that the value of a firm is dependent upon:
A. the firm's capital structure.
B. the total cash flow of the firm.
C. minimizing the marketed claims.
D. the amount of marketed claims to that firm.
E. the size of the stockholders' claims.
F. None of the above.

5. The term "financial distress costs" includes which of the following?

I. Direct bankruptcy costs
II. Indirect bankruptcy costs
III. Direct costs related to being financially distressed, but not bankrupt
IV. Indirect costs related to being financially distressed, but not bankrupt
A. I only
B. III only
C. I and II only
D. III and IV only
E. I, II, III, and IV
F. None of the above.

6. Which of the following is/are helpful for evaluating the effect of leverage on a company's
risk and potential returns?
I. Estimated pro forma coverage ratios
II. The recognition that financing decisions do not affect firm or shareholder value
III. A range of earnings chart and proximity of expected EBIT to the breakeven value
IV. A conservative debt policy that obviates the need to evaluate risk
A. I only
B. III only
C. I and III only
D. II and III only
E. IV only
F. None of the above.

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Chapter 06 - The Financing Decision

7. In general, the capital structures used by non-financial U.S. firms:

A. typically result in debt-to-asset ratios between 60 and 80 percent.
B. tend to converge to the same proportions of debt and equity.
C. tend to be those that maximize the use of the firm's available tax shelters.
D. vary significantly across industries.
E. None of the above.

8. Which of the following factors favor the issuance of debt in the financing decision?
I. Market signaling
II. Distress costs
III. Tax benefits
IV. Financial flexibility
A. I and II only
B. I and III only
C. II and IV only
D. I, II, and III only
E. I, II, and IV only
F. None of the above.

9. Which of the following factors favor the issuance of equity in the financing decision?
I. Market signaling
II. Distress costs
III. Management incentives
IV. Financial flexibility
A. I and II only
B. I and III only
C. II and IV only
D. II, III, and IV only
E. I, II, and IV only
F. None of the above.

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Chapter 06 - The Financing Decision

10. Which of the following factors favor the issuance of debt in the financing decision?
I. Market signaling
II. Distress costs
III. Management incentives
IV. Financial flexibility
A. I and II only
B. I and III only
C. II and IV only
D. I, II, and III only
E. I, II, and IV only
F. None of the above.

11. Which of the following is NOT a likely financing policy for a rapidly growing business?
A. Adopt a modest dividend payout policy that enables the company to finance most of its
growth externally.
B. Borrow funds rather than limit growth, thereby limiting growth only as a last resort.
C. Maintain a conservative leverage ratio to ensure continuous access to financial markets.
D. If external financing is necessary, use debt to the point it does not affect financial
flexibility.
E. None of the above.

12. According to the pecking-order theory proposed by Stewart Myers of MIT, which of the
following are correct?
I. For financing needs, firms prefer to first tap internal sources such as retained profits and
excess cash.
II. There is an inverse relationship between a firm's profit level and its debt level.
III. Firms prefer to issue new equity rather than source external debt.
IV. A firm's capital structure is dictated by its need for external financing.
A. I and III only
B. II and IV only
C. I, III, and IV only
D. I, II, and IV only
E. I, II, III, and IV
F. None of the above.

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Chapter 06 - The Financing Decision

As the financial vice president for Squamish Equipment, you have the following information:

13. For next year, calculate Squamish's times burden covered ratio if Squamish sells 2 million
new shares at $20 a share.
A. 1.03
B. 1.38
C. 1.60
D. 1.89
E. 2.10
F. None of the above.

14. For next year, calculate Squamish's earnings per share if Squamish sells 2 million new
shares at $20 a share.
A. 1.28
B. 1.39
C. 2.00
D. 2.22
E. 4.00
F. None of the above.

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Chapter 06 - The Financing Decision

15. Calculate Squamish's times interest earned ratio for next year assuming the firm raises $40
million of new debt at an interest rate of 7 percent.
A. 2.00
B. 3.09
C. 3.66
D. 4.35
E. None of the above.

16. Calculate Squamish's times burden covered ratio for the next year assuming annual
sinking fund payments on the new debt will equal $8 million.
A. 1.01
B. 1.08
C. 1.38
D. 1.49
E. 1.95
F. None of the above.

17. Calculate Squamish's earnings per share next year assuming Squamish raises $40 million
of new debt at an interest rate of 7 percent.
A. 1.28
B. 2.00
C. 2.12
D. 2.22
E. 3.06
F. None of the above.

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Chapter 06 - The Financing Decision

18. The interest tax shield has no value when a firm has:
I. no taxable income.
II. debt-equity ratio of 1.
III. zero debt.
IV. no leverage.
A. I and III only
B. II and IV only
C. I, III, and IV only
D. II, III, and IV only
E. I, II, and IV only
F. None of the above.

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2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.